The Danger of Leveraging Returns

The simple equation incorporates the following elements to calculate the effective rate of return for an investment made with borrowed money:

The Nominal Rate of Return - what the rate of return is on the whole amount invested, which is the prospective gain for the investor.

The Cost of Borrowing - the interest rate charged by the lender.

The Percentage of Your Down Payment - the percentage of the whole amount made up by money out of the investor's own pocket.

We've built a tool to calculated the leveraged rate of return for an investment that takes these factors into account, but we've added an extra wrinkle - the tax rate that might apply for the return on the investment, which is also something that can greatly affect the investor's choice of investment and can definitely affect their returns!

Leveraged Investment Data

Input Data

Values

Nominal Rate of Return [%]

Cost of Borrowing (Lender's Interest Rate) [%]

Percentage of Money Down (Investor's Own Money in Investment) [%]

Tax Rate on Return [%]

Leveraged Rate of Return

Calculated Results

Values

After Tax Rate of Return [%]

The default numbers in our tool above are taken from Chris Arnade's example in his post, but the 23.8% tax rate we've entered corresponds to the capital gains tax rate that took effect on 1 January 2013 (assuming this were an investment to which this tax rate would apply).

In Arnade's example, which assumed a tax-free nominal rate of return (or an after-tax rate of return), the leveraged rate of return was 15%. Imposing a tax rate of 23.8% as in our example reduces the effective rate of return of the leveraged investment to 6.67%.

But, if the investor didn't leverage the investment, putting 100% of their own money into it, the after tax rate of return would be 5.53%.

So there's still an advantage for an investor seeking to leverage their investment by borrowing a large portion of the total funds they will invest, but the taxes take a large portion of the leveraged gains out of the picture for the investor.

But we can certainly see the huge incentive that an investor would have for leveraging their investment if it were not subject to taxes, much as many municipal bonds are.

Could the same kind of leveraged bubble that led to the collapse of the financial industry in 2008 be at work in the municipal bond market today? ETF Trend's John Spence summarizes the growing concerns:

"Investors are looking for ways that they can pick up yield, especially munis, which have the tax advantage on the income," said Matthew Tucker, head of iShares fixed-income strategy, in the report. [Muni Bond ETF Rally]

Yet the muni bond rally has raised concerns the asset class has "gotten pricey and risky at the same time," reports Jason Zweig at The Wall Street Journal.

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